The Role of Existing Insurance Trusts in Divorce

Step 1: Collect Documents

The first step is to collect the documents essential to assess the current status of insurance trusts and insurance. Unfortunately, even apart from the difficulties the parties' divorce creates, few clients tend to organize and maintain their insurance records.

You need to obtain a copy of each signed insurance trust. Typically, if only one spouse worked, the ILIT will be for that spouse. If both spouses worked, each spouse may have his or her own ILIT to own insurance on his or her life. If the couple had sufficient wealth to be concerned about estate taxes, or in other situations where asset protection was a significant planning objective (even if the estate was not large enough for estate tax concerns), a third trust owning insurance on both spouses lives (survivorship or second-to-die insurance) may exist. You need to obtain a copy of each fully executed ILIT.

Copies of each insurance policy should be obtained, including the application pages in the back to ascertain the owners of the policy. Often, clients believe policies are owned by an ILIT, but the agent never properly transferred the policy into the trust. Most ILITs include special powers or rights, called 'Crummey powers' that permit beneficiaries the right to withdraw monies contributed to the trust during a window, typically 30-60 days following the date of the gift to the trust. This power is included in order for gifts to the trust to be characterized as present interest gifts that qualify for the gift tax annual exclusion. This is important for several reasons. The holders of these powers will have the right to withdraw future contributions and that may need to be addressed in the divorce negotiations. If the existence of these powers was not acknowledged in each year that gifts were made to the ILIT, then a portion of the grantor's lifetime gift tax exclusion ($1 million) may have been used and this could be an important fact to address as well. Finally, the parties who will have to sign these acknowledgments in the future may refuse to do so, and this possibility needs to be addressed.

A copy of a recent bank account statement should be obtained. This is important to identify how much cash is on hand in the account. If the amounts are small, that implies that all future premiums will have to be funded. In some unusual situations the amounts might be quite large, and thus important to identify. This could result from a cash value policy having been surrendered or, in unusual circumstances, an effort to hide assets under another tax identification number.

A copy of a recent trust income tax return, Form 1041, should be obtained as well, or if none has been filed, a confirmation of that fact. In most cases, income tax returns are not filed by ILITs because they are characterized as grantor trusts for income tax purposes. This means all income is simply reported on the grantor's income tax return. However, some accountants will file what is often referred to as 'skeleton' income tax returns. These are basically blank returns with a statement attached indicating that the trust is a grantor trust and disclosing the tax identification number and name of the grantor on whose personal income tax return the trust income is reported. In other instances, and that is an important reason to request the trust income tax return, an income tax return will be filed and will reflect trust income. That income may indicate other trust assets that could be important to your analysis.

Step 2: Analyze Current Circumstances and Facts

Once the documentation has been obtained, some analysis of the current circumstances is required.

Insured's Health

The health status of each insured spouse is important to understand in general terms. If there are current health issues that affect the cost of obtaining new insurance, or even the ability to obtain insurance at any cost, this will be critical to the analysis. If there are health problems it might be advisable, or even essential, to find a method of maintaining old insurance policies and ILITs as other options may be impractical or non-existent. In many divorce agreements, insurance requirements are mandated, but the type and quality of coverage is not addressed. If your client's ex-spouse has significant alimony and child support obligations, and the PSA mandates $1 million of coverage with no other details, a one-year term policy could be purchased. If health issues develop a few years post-divorce, it may be impossible to obtain continued coverage. If comparable permanent insurance is owned by an existing ILIT, using that to meet the PSA insurance requirements may be important to your clients' financial security.

Existing Insurance Policy and Issuer Status

In order to address the proper planning for your client, you will need to know the quality of existing insurance held by an ILIT. If it is marginal, or the policy has not performed well and might implode if the current premium payment pattern is continued, you will need to know this. These are issues that an insurance expert, not an attorney, should address. If, however, the policy is with a solid company and has performed well, the incentives to use that policy to meet PSA insurance requirements is greater.

Current Insurance Rates

Even if the existing policies are performing well, if comparable new coverage can be obtained at a lower cost, it may not be worth the bother addressing existing policies.

Step 3: Establish Insurance Objectives

What are the objectives and requirements for insurance in the divorce? This analysis is no different from the analysis that is traditionally completed. It warrants noting, because it is an essential step in the process of reviewing existing coverage and ILITs.

Step 4: Review Existing ILIT To See If and How Objectives Can Be Achieved

Review ILITs in Light of Insurance Objectives

Once the objectives are identified, you can review the existing facts'including, in particular, the existing trust documentation ' to determine whether the existing facts can be tailored to meet your client's needs.

'Irrevocable' Does Not Mean the ILIT Cannot Be Changed

The key hurdle in dealing with an existing insurance trust is how to address the fact that it is irrevocable. Most, if not all, ILITs are irrevocable in order to assure that the life insurance proceeds are not taxable in either spouse's estate. Irrevocability does not necessarily mean incapable of modification, although depending upon the terms of the trust, it might. There are several provisions that practitioners can consider when reviewing a trust in order to modify and better serve post-divorce needs.

Trust Protector

In some newer or more sophisticated trusts, a special fiduciary position typically called 'trust protector' or 'trust adviser' is created. General-
izations are dangerous because the specific terms of this fiduciary function can vary considerably among those trusts that do include it. In a typical trust protector arrangement ' if that is the appropriate moniker ' the trust protector may have the authority to terminate current trustees and replace them with new trustees, change the governing law and situs of the trust, and take other certain big picture actions. If the trust protector's powers include these rights, it may be relatively simple to change existing trustees (e.g., from your client's evil ex-brother in law) to a new trustee that is independent (e.g., an agreed-upon third party, a bank, etc.) and, hence more suitable to the post-divorce environment. Trust protector actions are typically taken by written notice to the other fiduciaries and perhaps beneficiaries, depending upon the terms of the trust. Most state laws still have no provisions governing this fiduciary position so that the terms of the trust will have to be relied upon. If the spouse and children to be benefited are relocating as a result of the divorce, it may also be advisable to change the situs and governing law to the new state.

Trustee Resignations and Reappointments

One of the most sensitive issues in handling a post-divorce trust is determining who the trustees are. Typically, these were drawn from friends and family members who may have taken sides post-divorce. In most events, naming a neutral party is an excellent approach to minimizing post-divorce conflict and assuring that the provisions of the PSA are independently and objectively carried out. The provisions appointing trustees should be reviewed carefully. Many, though not all, older trusts do provide some mechanism for a trustee to resign formally, and for new or successor trustees to be replaced. Usually, in a post-divorce situation some juggling and massaging of these provisions is necessary, given the dramatic and unanticipated changes in trustee appointments that are typically needed. In many cases, a series or succession of trustees will all have to resign in order for a new trustee that is acceptable to be appointed. Ideally, all these issues should be addressed at the PSA stage so that all the appropriate resignations can be obtained as part of a comprehensive settlement. Otherwise, for example, a recalcitrant sibling of an ex-spouse may not be willing to resign as a trustee in order to enable an appropriate independent or non-adversarial successor trustee to step in.

Terminate the Old Trust and Transfer Assets to a New One

In many instances, the old trust is simply not a workable solution for the post-divorce realities, but the insurance coverage is advantageous to maintain. The changes may be too significant, or the trust document may not be flexible enough to permit such changes. All is not necessarily lost, as in many trusts there may be
a sufficient basis, or even specific provisions, permitting the trustee of that trust to distribute assets to a new trust for the same beneficiaries. So, for example, a trust exists with insurance on a spouse who may no longer be insurable or only insurable at higher rates, but the trust itself provided for a distribution to children in a manner that is no longer acceptable (e.g., outright distribution at age 21). The terms of the trust may allow the trustees, and perhaps others, depending upon the terms of the trust, to sign a consent to transfer all trust assets to a new successor trust for the same children. The new trust could be designed to assure that the money is in the trust and used specifically for education, or to meet other requirements of settling the matrimonial dispute. In this instance, it would be ideal to have the termination and transfer consent document executed as part of the overall matrimonial settlement and the new trust signed and in place before the consent is signed so that the terms of the new trust are agreed upon by all parties. This can be an extremely useful technique to preserve existing insurance policies, by placing them in a structure that is consistent with post-divorce realities. If any rights of beneficiaries under the old trust are modified in the course of a transfer to a new trust, caution should be exercised. As indicated above, the parties may agree that assets should be held in trust until the beneficiaries reach an older age. This may create claims by those beneficiaries against the trustees, their parents, and others. The risks of this must be assessed and a determination made as to what steps might minimize the risks.

Loose Ends to Address

One of the issues in many trusts is whether or not the trust should file ' or has filed ' income tax returns. Most life insurance trusts have little, if any, income and are characterized so that their income tax status is irrelevant. However, many trusts do have income-earning assets. For example, in many cases, clients have funded trusts with assets in excess of the insurance premiums so they have built up an investment component to the trust, even if such a result was not intended at the initial ILIT drafting stage. In other situations, which are quite common, insurance companies have de-mutualized and the shares of stock held by the trust pay dividends creating an income tax issue. Many insurance trusts should be appropriately characterized as grantor trusts for income tax purposes. This means that the income from the trust is reportable on the personal income tax return of the grantor to the trust. If this is a correct classification, then the income tax on assets in the ILIT will be paid by the grantor. So, for example, if the husband set up an insurance trust that has assets producing income, he will have to pay the income tax post-divorce (as well as prior to the divorce) on the income in that trust. This may have been an acceptable arrangement prior to the divorce from the standpoint that it was all the same family assets and a joint tax return. Post-divorce, this may be objectionable to the grantor ex-husband because he would be paying income tax on assets from which he receives no benefit. If this is the situation, it should be clarified in the PSA.

If there is a grantor trust issue, it could either be dealt with by an adjustment to other economic arrangements under the property settlement. In the alternative, many trusts will permit a plan to be devised to distribute funds to the children or custodial accounts for the children to remove the income producing assets that are held by the trust and, thus, obviate the problem.

The conclusion of this article will provide sample clauses to include in the PSA relating to the ILIT.

Martin M. Shenkman, CPA, MBA, JD, is a member of this newsletter's Board of Editors, and is an estate planner in New York City and Teaneck, NJ. His Web site, http://www.laweasy.com/, has information on matrimonial, investment and related matters.

Life insurance is a common issue addressed in a substantial proportion of divorces. For many clients, especially those of greater economic means, existing insurance coverage is owned by irrevocable life insurance trusts ('ILIT'). Existing ILIT arrangements too often receive inadequate attention during the course of a divorce as a result of the focus on other more significant issues, or the presumption that since the ILIT is 'irrevocable,' it cannot be tailored to address the post-divorce insurance needs. This can be a considerable mistake. In many cases, because it is assumed that an existing ILIT cannot be changed, the insurance requirements resulting from the divorce are separately addressed in a property settlement agreement ('PSA').

For example, a husband may have funded an insurance trust ten years previously, when the marriage was solid, and the trust may have purchased insurance on his life. Rather than addressing how that pre-existing ILIT can be dealt with, in most cases the PSA will simply mandate new minimum insurance requirements that the ex-husband has to provide for the ex-wife and children. In many cases, better, or less costly coverage can be obtained through modifications of the existing insurance trust. In some cases, due to health or other factors, it becomes essential to deal with the existing insurance trust.

To address existing ILITs in the context of a divorce, there are five steps that practitioners must take; the fifth will appear in the next issue of The Matrimonial Strategist.

Step 1: Collect Documents

The first step is to collect the documents essential to assess the current status of insurance trusts and insurance. Unfortunately, even apart from the difficulties the parties' divorce creates, few clients tend to organize and maintain their insurance records.

You need to obtain a copy of each signed insurance trust. Typically, if only one spouse worked, the ILIT will be for that spouse. If both spouses worked, each spouse may have his or her own ILIT to own insurance on his or her life. If the couple had sufficient wealth to be concerned about estate taxes, or in other situations where asset protection was a significant planning objective (even if the estate was not large enough for estate tax concerns), a third trust owning insurance on both spouses lives (survivorship or second-to-die insurance) may exist. You need to obtain a copy of each fully executed ILIT.

Copies of each insurance policy should be obtained, including the application pages in the back to ascertain the owners of the policy. Often, clients believe policies are owned by an ILIT, but the agent never properly transferred the policy into the trust. Most ILITs include special powers or rights, called 'Crummey powers' that permit beneficiaries the right to withdraw monies contributed to the trust during a window, typically 30-60 days following the date of the gift to the trust. This power is included in order for gifts to the trust to be characterized as present interest gifts that qualify for the gift tax annual exclusion. This is important for several reasons. The holders of these powers will have the right to withdraw future contributions and that may need to be addressed in the divorce negotiations. If the existence of these powers was not acknowledged in each year that gifts were made to the ILIT, then a portion of the grantor's lifetime gift tax exclusion ($1 million) may have been used and this could be an important fact to address as well. Finally, the parties who will have to sign these acknowledgments in the future may refuse to do so, and this possibility needs to be addressed.

A copy of a recent bank account statement should be obtained. This is important to identify how much cash is on hand in the account. If the amounts are small, that implies that all future premiums will have to be funded. In some unusual situations the amounts might be quite large, and thus important to identify. This could result from a cash value policy having been surrendered or, in unusual circumstances, an effort to hide assets under another tax identification number.

A copy of a recent trust income tax return, Form 1041, should be obtained as well, or if none has been filed, a confirmation of that fact. In most cases, income tax returns are not filed by ILITs because they are characterized as grantor trusts for income tax purposes. This means all income is simply reported on the grantor's income tax return. However, some accountants will file what is often referred to as 'skeleton' income tax returns. These are basically blank returns with a statement attached indicating that the trust is a grantor trust and disclosing the tax identification number and name of the grantor on whose personal income tax return the trust income is reported. In other instances, and that is an important reason to request the trust income tax return, an income tax return will be filed and will reflect trust income. That income may indicate other trust assets that could be important to your analysis.

Step 2: Analyze Current Circumstances and Facts

Once the documentation has been obtained, some analysis of the current circumstances is required.

Insured's Health

The health status of each insured spouse is important to understand in general terms. If there are current health issues that affect the cost of obtaining new insurance, or even the ability to obtain insurance at any cost, this will be critical to the analysis. If there are health problems it might be advisable, or even essential, to find a method of maintaining old insurance policies and ILITs as other options may be impractical or non-existent. In many divorce agreements, insurance requirements are mandated, but the type and quality of coverage is not addressed. If your client's ex-spouse has significant alimony and child support obligations, and the PSA mandates $1 million of coverage with no other details, a one-year term policy could be purchased. If health issues develop a few years post-divorce, it may be impossible to obtain continued coverage. If comparable permanent insurance is owned by an existing ILIT, using that to meet the PSA insurance requirements may be important to your clients' financial security.

Existing Insurance Policy and Issuer Status

In order to address the proper planning for your client, you will need to know the quality of existing insurance held by an ILIT. If it is marginal, or the policy has not performed well and might implode if the current premium payment pattern is continued, you will need to know this. These are issues that an insurance expert, not an attorney, should address. If, however, the policy is with a solid company and has performed well, the incentives to use that policy to meet PSA insurance requirements is greater.

Current Insurance Rates

Even if the existing policies are performing well, if comparable new coverage can be obtained at a lower cost, it may not be worth the bother addressing existing policies.

Step 3: Establish Insurance Objectives

What are the objectives and requirements for insurance in the divorce? This analysis is no different from the analysis that is traditionally completed. It warrants noting, because it is an essential step in the process of reviewing existing coverage and ILITs.

Step 4: Review Existing ILIT To See If and How Objectives Can Be Achieved

Review ILITs in Light of Insurance Objectives

Once the objectives are identified, you can review the existing facts'including, in particular, the existing trust documentation ' to determine whether the existing facts can be tailored to meet your client's needs.

'Irrevocable' Does Not Mean the ILIT Cannot Be Changed

The key hurdle in dealing with an existing insurance trust is how to address the fact that it is irrevocable. Most, if not all, ILITs are irrevocable in order to assure that the life insurance proceeds are not taxable in either spouse's estate. Irrevocability does not necessarily mean incapable of modification, although depending upon the terms of the trust, it might. There are several provisions that practitioners can consider when reviewing a trust in order to modify and better serve post-divorce needs.

Trust Protector

In some newer or more sophisticated trusts, a special fiduciary position typically called 'trust protector' or 'trust adviser' is created. General-
izations are dangerous because the specific terms of this fiduciary function can vary considerably among those trusts that do include it. In a typical trust protector arrangement ' if that is the appropriate moniker ' the trust protector may have the authority to terminate current trustees and replace them with new trustees, change the governing law and situs of the trust, and take other certain big picture actions. If the trust protector's powers include these rights, it may be relatively simple to change existing trustees (e.g., from your client's evil ex-brother in law) to a new trustee that is independent (e.g., an agreed-upon third party, a bank, etc.) and, hence more suitable to the post-divorce environment. Trust protector actions are typically taken by written notice to the other fiduciaries and perhaps beneficiaries, depending upon the terms of the trust. Most state laws still have no provisions governing this fiduciary position so that the terms of the trust will have to be relied upon. If the spouse and children to be benefited are relocating as a result of the divorce, it may also be advisable to change the situs and governing law to the new state.

Trustee Resignations and Reappointments

One of the most sensitive issues in handling a post-divorce trust is determining who the trustees are. Typically, these were drawn from friends and family members who may have taken sides post-divorce. In most events, naming a neutral party is an excellent approach to minimizing post-divorce conflict and assuring that the provisions of the PSA are independently and objectively carried out. The provisions appointing trustees should be reviewed carefully. Many, though not all, older trusts do provide some mechanism for a trustee to resign formally, and for new or successor trustees to be replaced. Usually, in a post-divorce situation some juggling and massaging of these provisions is necessary, given the dramatic and unanticipated changes in trustee appointments that are typically needed. In many cases, a series or succession of trustees will all have to resign in order for a new trustee that is acceptable to be appointed. Ideally, all these issues should be addressed at the PSA stage so that all the appropriate resignations can be obtained as part of a comprehensive settlement. Otherwise, for example, a recalcitrant sibling of an ex-spouse may not be willing to resign as a trustee in order to enable an appropriate independent or non-adversarial successor trustee to step in.

Terminate the Old Trust and Transfer Assets to a New One

In many instances, the old trust is simply not a workable solution for the post-divorce realities, but the insurance coverage is advantageous to maintain. The changes may be too significant, or the trust document may not be flexible enough to permit such changes. All is not necessarily lost, as in many trusts there may be
a sufficient basis, or even specific provisions, permitting the trustee of that trust to distribute assets to a new trust for the same beneficiaries. So, for example, a trust exists with insurance on a spouse who may no longer be insurable or only insurable at higher rates, but the trust itself provided for a distribution to children in a manner that is no longer acceptable (e.g., outright distribution at age 21). The terms of the trust may allow the trustees, and perhaps others, depending upon the terms of the trust, to sign a consent to transfer all trust assets to a new successor trust for the same children. The new trust could be designed to assure that the money is in the trust and used specifically for education, or to meet other requirements of settling the matrimonial dispute. In this instance, it would be ideal to have the termination and transfer consent document executed as part of the overall matrimonial settlement and the new trust signed and in place before the consent is signed so that the terms of the new trust are agreed upon by all parties. This can be an extremely useful technique to preserve existing insurance policies, by placing them in a structure that is consistent with post-divorce realities. If any rights of beneficiaries under the old trust are modified in the course of a transfer to a new trust, caution should be exercised. As indicated above, the parties may agree that assets should be held in trust until the beneficiaries reach an older age. This may create claims by those beneficiaries against the trustees, their parents, and others. The risks of this must be assessed and a determination made as to what steps might minimize the risks.

Loose Ends to Address

One of the issues in many trusts is whether or not the trust should file ' or has filed ' income tax returns. Most life insurance trusts have little, if any, income and are characterized so that their income tax status is irrelevant. However, many trusts do have income-earning assets. For example, in many cases, clients have funded trusts with assets in excess of the insurance premiums so they have built up an investment component to the trust, even if such a result was not intended at the initial ILIT drafting stage. In other situations, which are quite common, insurance companies have de-mutualized and the shares of stock held by the trust pay dividends creating an income tax issue. Many insurance trusts should be appropriately characterized as grantor trusts for income tax purposes. This means that the income from the trust is reportable on the personal income tax return of the grantor to the trust. If this is a correct classification, then the income tax on assets in the ILIT will be paid by the grantor. So, for example, if the husband set up an insurance trust that has assets producing income, he will have to pay the income tax post-divorce (as well as prior to the divorce) on the income in that trust. This may have been an acceptable arrangement prior to the divorce from the standpoint that it was all the same family assets and a joint tax return. Post-divorce, this may be objectionable to the grantor ex-husband because he would be paying income tax on assets from which he receives no benefit. If this is the situation, it should be clarified in the PSA.

If there is a grantor trust issue, it could either be dealt with by an adjustment to other economic arrangements under the property settlement. In the alternative, many trusts will permit a plan to be devised to distribute funds to the children or custodial accounts for the children to remove the income producing assets that are held by the trust and, thus, obviate the problem.

The conclusion of this article will provide sample clauses to include in the PSA relating to the ILIT.

Martin M. Shenkman, CPA, MBA, JD, is a member of this newsletter's Board of Editors, and is an estate planner in New York City and Teaneck, NJ. His Web site, http://www.laweasy.com/, has information on matrimonial, investment and related matters.